Equities Trade “DIRTY” – What that Means and Why it Matters

Overview: The purpose of this whitepaper is to educate readers about a flaw in our market structure, that causes income-producing securities to trade “Dirty." Dirty security pricing causes investors to pay inflated values for income-producing securities and then...

Resistance to change on the part of mutual fund companies ETFs has cost them many assets over the years – especially when those changes benefit investors’ after-tax returns.  ETFs tangibly improved after-tax-and-fee returns, transparency, efficiency, and accessibility for fund investors.  Yet, most of the established mutual fund providers spent 15 years fighting the “structural alpha” inherent in ETFs instead of embracing it and capturing it for their investors.  The same is true of advances in online trading technologies that empowered investors while drastically lowering costs.  This article discusses the latest FinTech improvement with inherent structural alpha and whether fund companies will embrace or resist its benefits to their investors.  The technology is known as FairShares.

Mutual fund shares trade unfairly and inefficiently to the detriment of investor returns. The unfairness in question was never purposeful. It’s simply another example of how antiquated technologies and accounting principles are still the standard methods used in the investment industry. It is still the case that capital gains and dividend distributions are determined based upon the “last holder of record” at a designated date. It has always been done this way.

The problem is that this method results in different tax and wealth implications for different investors based on the dates that they buy or sell shares. In everything else they do, US businesses use GAAP accounting which specifies daily accruals, assuring evenly spread profits, losses, and costs to assets and liabilities. The discontinuous and uneven manner of recording these distributions and payments in a last holder of record payment system periodically allows investment managers for certain classes of investors, especially high net worth individuals and family offices, to implement tax arbitrage and dividend arbitrage strategies in attempts to minimize tax bills while fully realizing income. This means that certain classes of individuals benefit at the expense of others. One of the stated missions of the US Securities and Exchange Commission is precisely to prevent this from happening.

With technology comes the ability to improve upon age-old inefficiencies. FairShares, a FinTech company based in Delray Beach, FL, has engaged me as a Senior Advisor to confirm the fact that their technology can allow fund companies to seamlessly install their systems and methods cheaply and efficiently into any investment fund to transform “last holder of record” accounting to GAAP-prescribed accrual accounting. Applying GAAP accrual accounting to a fund’s realized income improves the investment returns and buying power of all investors.

As with ETFs, I’ve experienced quite a bit of initial resistance in imploring mutual fund companies simply to take a look at the technology; let alone the benefits of making the processes fairer to fund shareholders. But this time, the FairShares team has taken several mutual fund, accounting, and market regulatory experts through the deep dive and corresponding math. Almost universally, the reaction was surprise that capital gain and dividend distributions weren’t already being handled by mutual funds this way as the FairShares methods are far more equitable and consistent with GAAP and in the best interest of their shareholders.

Once the fact that accruing dividends and capital gains as payable liabilities was fairer to investors and the marketplace, something certain to resonate with the US Securities and Exchange Commission and FINRA, the next question is whether the differences for fund shareholders are significant. The answer is a resounding yes. We estimate that FairShares can help fund companies and their shareholders in the aggregate save tens of billion dollars in wasteful frictional costs every year.

Much of the difference surrounds two issues:

1)   Investors are forced to overpay for investment funds they buy because they are buying two separate interests upon each purchase. They are buying an interest in the fund’s realized income (dividends and capital gains) plus an additional interest in the fund’s underlying investments. There is no economic value in buying dividends and capital gains. “Buying a dividend” is a risk that is disclosed in each fund’s prospectus. Therefore, investors are paying more for an investment fund than it is worth. This means they are buying fewer shares than they would otherwise buy if dividends and capital gains were not included in a security’s price.

2)   When the dividends and capital gains an investor purchased are ultimately returned to the investor via a distribution, they are considered taxable income. Therefore, investors are being taxed on a return of their own capital. In essence, taxable investors are trading $1.00 for $.60 by exchanging an after-tax dollar for a pre-tax dollar.

For years, mutual fund investors have been persuaded to dollar cost average their contribution. This naïve approach makes them fair game to be picked off by tax arbitrageurs and dividend arbitrageurs who time when they buy and sell fund shares in an effort to maximize after-tax returns. 

The implications of the benefits of the FairShares patent-pending processes in equitable shareholder treatment and increased wealth capture for most investors go well beyond equity mutual funds. In fact, the benefits are probably greater in most fixed income funds. 

As many of you are well aware, I’ve been working in the Responsible Investing and ESG areas for many years including being on the Board of Skytop Strategies. With mutual funds so key to many of our retirements and our future, this issue should not continue to be ignored.

If mutual fund complexes are made aware that a simple cost-effective change can make their fund-shares fairer and generally more profitable to their investors, they have a fiduciary obligation to do so and need to be transparent about that. Responsible financial organizations should lead by example.  In short, the FairShares methodology should soon be recognized as a Best Practice and become the standard of the Mutual Fund industry.


Herb Blank

Senior Advisor

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